What Is the Allowance Method? Definition and Comparison
Updated February 3, 2023
Not all customers who intend to pay back credit do. The allowance method helps businesses estimate the debt risk at the time of the original purchase and allows them to retrieve the otherwise unrecoverable debt or receivable.
In this article, we look at what an allowance method is and how it differs from the write-off method and provide an example of the allowance method in practice.
What is the allowance method?
The allowance method refers to one of the two ways for reporting bad debts expenses that results from a company selling goods or services on credit. A business will set aside a certain amount of funds to cover bad debts—or money that probably won’t be repaid to them—and is typically calculated as a percentage based on company sales (in a previous sales period) and specific customer risk assessment.
By preparing themselves for this loss, businesses can better predict what their profits will be at the end of a sales period. Financial statements are also generally more accurate when businesses use the allowance method to account for possible bad debt expenses.
Example of allowance method
A business provides services to a customer on January 1 with a credit cycle of net 30 days—the credit must be paid back in 30 days. Historically, 0.4% of business credit transactions have gone unpaid.
To calculate its debt allowance, the business calculates 0.4% of $500,000—January’s credit transactions:
0.4% x $500,000= $2,000
At the end of the month, the business records a debt allowance of $2,000 and debits this amount from the total credit transactions:
$500,000 - $2,000= $498,000
How to calculate your debt allowance
There are multiple ways to calculate your debt allowance. To determine how much to “allow” in your budget for bad debt in a sales period, start with historical data and try the following percentage calculations:
1. Percentage of sales
Start by reviewing financial reports from previous quarters and/or years to find a debt pattern by amount. Calculate the average percentage of unrecoverable debt-to-sales income ratio for those time periods. Use that same percentage to estimate what percentage of your projected annual sales will be unrecoverable debt.
Example: A business reviews its previous year’s financial income and discovers that 3% of credit transactions were unrecoverable. The annual sales income for that year was $210,000. They determine that $6,300 was unpaid debt. If the business projects about the same sales for the current year, it can estimate its year-end bad debt as $6,300.
The calculation would look like the following:
$210,000 x 3% = $6,300
Bad debt: -$6,300
Credit allowance for bad debt: $6,300
2. Percentage of accounts receivable
Instead of using sales total percentages to forecast your debt allowance, review previous financial records for other patterns, such as when bad debt occurred or how it occurred.
Example: A business reviews last year’s financials and sees a trend that 60% of credit transactions over 90 days and 0.7% of credit transactions over 30 days were unpaid. Based on these findings, you estimate the same allowance percentages for the current year. Based on this historical data, the business would set aside 60% and 0.7% of sales, respectively, in preparation for the future estimated loss.
This approach uses a balance sheet that lists the timing schedule by the days the accounts are overdue, an estimated percentage of bad debts, the accounts receivable balance and the allowance for bad debts.
Allowance figured for unrecoverable debt balances the accounts receivable, which helps identify the net realizable value.
Direct write-off method vs. allowance method
Businesses typically use one of two methods to account for unrecoverable debt: the allowance method and the direct write-off method. The allowance method anticipates and prepares for a certain amount of unpaid debt while the direct write-off method deals with the debt only after it hasn’t been paid.
The allowance method does actually “write-off” the debt as “bad debt,” but it does so preemptively, so the business is not surprised or financially upset by unrecovered debts. The allowance method can be better for a business than the direct write-off method because:
The bad debts expense closer to the point of the sale or service.
The allowance prepares a more accurate estimation of end-of-period financials, so the business knows what they have and how to prepare.
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